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Tuesday, January 24, 2017

Macro Musings Podcast: Gauti Eggertsson

My latest Macro Musings is with Gauti Eggertson. Gauti is a professor of economics at Brown University and formerly worked in the research departments of the International Monetary Fund and the Federal Reserve Bank of New York. He has written widely on liquidity traps, deflation, and the zero lower bound (ZLB) and joined me to talk about these issues.

This was a fun conversation and a good look back at the challenges and shortcomings of macroeconomic policy since the crisis in 2008. One of the big takeaways from our conversation, at least for me, is that central banks during this time ignored many of the key findings in the literature when it comes to best practices at the ZLB.

Before getting to these missed opportunities, it is worth recalling the nature of the ZLB problem. It emerges when there has been a severe recession that forces down the 'natural' or market-clearing level of short-term interest rates to a level well below 0%. The Fed's normal response, lowering interest rates to the level of the natural interest rate, does not work here because the Fed will run up against a lower bound where people would rather hold cash than earn a negative interest rate on their deposits. This lower bound is effectively a price floor that prevents the economy from properly healing and quickly returning to full employment.

So what can policymakers do? Gauti's work gives an answer. Specifically, his 2003 paper with Michael Woodford (which builds upon Paul Krugman's 1998 paper) shows that policymakers need to credibly commit to an expected path of interest rates that will restore the pre-crisis path of the price level. Put differently, Gauti's work implies the best defense against and escape from a depressed economy is some kind of level targeting. Gauti favors an output-gap adjusted price level target. As Michael Woodford noted in his 2011 talk, this effectively amounts to a nominal GDP level target or restoring the growth path of nominal spending.

One implication of this understanding is that if there is any disinflation or deflation from a collapse in aggregate demand during a recession there needs to be an offsetting period of reflation to restore the aggregate demand growth path. This did not happen after 2008 and implies aggregate demand growth was persistently weak. This was a missed opportunity by the Fed.

The Fed, instead, tried various rounds of QE. And it did so in exactly the manner that Eggertson and Woodford (2003) and Krugman (1998) said would lead to the famous 'irrelevance results'. That is, the Fed did these programs using temporary monetary base injections, whereas only permanent injections matter.

What is truly surprising about this observation is that the permanent injections point is widely understood. For example, here is a list of prominent New Keynesians who acknowledge it (including former Fed chair Ben Bernanke). And here is a list of quantity theory advocates making the same point.

To be clear, this point does not mean QE will have no effect. Rather, is says that temporary injections will not generate the robust aggregate demand growth needed to quickly escape a ZLB environment.

So why did the Fed ignore the literature and fall right into the irrelevance results trap? I have a working paper that takes a stab at this question. I argue there were both external forces (public's fear of inflation vented via Congress) as well as internal ones (Fed still fighting the last battle and suffering from loss aversion) that kept the Fed timid. In our interview, Gauti made an interesting observation related to this point. The Fed seemed okay being aggressive with QE, but not with reflation. It is a bit of puzzle why it was so bold in the former but timid in the later.

This was a fascinating conversation throughout. You can listen to the podcast on Soundcloud, iTunes, or your favorite podcast app. You can also listen via the embedded player above. And remember to subscribe since more episodes are coming.

P.S.

Gauti and I also touched on how best to sell level targeting to policymakers and the public. Here is a recent Bloomberg article that looks at Gauti's innovative attempt to do so at the New York Fed in 2010 using 'Inflation Budget Accounting". Below is an excerpt:

We suggest that the FOMC keeps track of the extent to which it has "missed" its inflation target. Let us call these accumulated misses "inflation debt". Hence if the inflation target is 2 percent, and inflation is at 1 percent for two years in a row, then the accumulated "inflation debt" is 2 percent.

The FOMC would then announce an "easing bias" until the inflation debt accumulated in the current recession has been extinguished. If this is credible, a deflationary reading of the data would signal a larger "easing bias" going forward.

P.P.S.

As I note in my working paper mentioned above, the Fed has been explicit about its plan to eventually shrink its balance sheet. It said so in its exit strategy plans reported in the June 2011 and September 2014 FOMC meetings. Janet Yellen recently reiterated those plans in her August 2016 Jackson Hole speech (see footnote 13). More recently, the Federal Reserve updated its basic guidebook to monetary policy in October 2016. Here too it stresses the balance sheet will be reduced:

As the policy normalization process proceeds, the Federal Reserve’s securities holdings—and the supply of reserve balances—will be reduced in a gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held in the portfolio...

The FOMC intends that the Federal Reserve will, over the longer run, hold no more securities than necessary to implement monetary policy efficiently and effectively, and that it will hold primarily Treasury securities (p.52)

And if there were any questions about what this means, the Fed later notes that "no more securities than necessary" means doing away with the overnight reverse repurchase facility:

During normalization, the Committee
is using an overnight reverse repurchase (ON RRP) facility as a supplementary tool as needed to help control the federal funds rate... The FOMC plans to use the ON RRP facility only to the extent necessary and will phase it out when it is no longer needed to help control the funds rate (p.51).

I would also add from a political economy perspective that the balance sheet will have to be reduced given IOR. The increasingly bad optics of the Fed paying banks larger interest payments as interest rates go up will force the Fed's hands on reducing its balance sheet.

14 comments:

David, you might find interesting this Fed blog note, which uses SEP projections and the FRB/US model to ask: what money supply path would be consistent SEP projections? You can see the money supply collapsing over the next few years.

Jens, as you know, the Fed can easily shrink the balance sheet by simply not reinvesting principal payments. This happened to some extent between QE1 and QE2 and got the Fed alarmed (see this this 2010 Bernanke speech).

Given this ability to passively shrink its balance sheet and given these excess reserves have had very little bearing on inflation anyways as noted above, it should not be hard to unwind them with little effect on inflation. The only real impediment I see is whether the recovery really takes hold in 2017 and allows this process to begin in earnest.

I get the irrelevance result and I very much agree with this way of analysing QE.

My thinking is that we have seen new sources of base money demand In recent years which means it is not trivial for Fed to just passively shrink its balance sheet.

For example change to treasury cash balance policy means it is demanding 500bn to hold on its account. Also, banks are holding 20-50% of the LCR buffer in cash and reserves. Since, LCR is a binding constraint you cannot shrink base money without affecting economy and inflation.

So I could a case for Fed reducing its balance a little bit corresponding to present use of reverse repos without affecting the economy. But more than that could be problematic.

Jens, the reduction of the monetary base will be offset by an equal increase in the number of treasury securities. These too can used with the LCR, no? Also, the reduction in the monetary base will not be back to 2008 level, but back to where its (roughly) trend growth path would be today.

Fed will need to figures out what to do with its MBS holding - that is not a substitute i LCR context. Further I am not sure treasuries and base money are close substitutes either. Just have a look at the market impact from the decline in the monetary base on the around the turn of the quarter due to increased use of reverse repos. This might be more of a Eurodollar issue but still.

Anyway, my point was simply that I think this warrants further investigation besides assuming it will be fine to extrapolate trend growth before 2008. By the way, which period should be the reference here? There seems to be a break in base money growth around 2006.

Jens, for purposes of the the Basel III requirement base money and treasuries are close substitutes for the 'high quality liquid assets' (HQLA) category that makes up the numerator. Moreover, GSE securities (MBS & other bonds) aren't far behind. They are slightly less perfect substitutes, but still usable as HQLA. So again, I don't see an issue here.

I do wonder about the "public's fear of inflation vented via Congress…."

My conversations in the U.S. indicate the public wants jobs and prosperity, and the arcana of Fed interventions is poorly understood. Sure, nobody wants 10% inflation, but who cares whether 3% to 2% to 4%? Would you even notice 3% vs. 2%?

This suggests it is not public pressure that twists the Fed's arm at times, but special-interest-group pressure. But from who?

The Fed is independent, and seems fearless when it comes to causing recessions to fight inflation. But when it comes to allowing a slightly higher rate of inflation to promote property, it loses its nerve? This is bowing to public pressure? Really?

Something does not add up here. Of course, a regulatory agency usually becomes "captured." The USDA works for the agriculture industry, for example.

Is there something about Fed policies that comes from regulating banks?

The IOER does seem like a USDA program applied to banks---getting income for doing nothing.

I think economists might wish to ponder the institutional politics of the Fed. Something does not add up.

I doubt it was the employees of American who twisted the Fed's arm into sustaining the slowest recovery in history after 2008.

Ben, as I noted above I suspect it was both the public and inertia at the Fed. However, I encourage you to look at my linked paper above. It shows some polling information that indicates inflation concerns shot up in 2008 and 2009. I suspect it was the large amount of gov't intervention in the economy that freaked people out. Recall all the inflation fears back then.

I have been following your remarks about under-production of safe assets for a number of years now, and they have been quite informative. But the one glaring hole in this account is the absence of any explanation of *why* the private sector has simply failed to produce sufficient quantities of safe assets for almost a decade.

I am not a bank balance sheet expert, but I've talked to some. From what I gather the big difference between the pre- and post-crisis situations is the presence of binding liquidity constraints now imposed on banks due to such Dodd-Frank/Basel3 constructs as the Liquidity Coverage Ratio. These constraints undermine the demand for privately produced safe assets (like senior CDO tranches structured from pools of corporate bonds or mortgages) by simply excluding them from legally defined categories like "High Quality Liquid Assets." (The regulatory definition of HQLAs prohibit reliance on complicated, model-driven valuation processes. But of course, it was precisely the innovation of such valuation processes that made it possible to privately produce vast swaths of safe assets in the first place.)

So it is not an inherent failure of the financial system to produce safe assets that explains the lingering shortage. It is post-crisis banking regulation. Achieving a superior monetary policy regime without undoing these regulations can't be expected to solve the safe asset shortage.

Eric, that is a fair point and I agree. I only question how important was this effect relative to the safe asset demand created by the economic weakness and ongoing uncertainty. I would like to see some estimates of how each one contributed to the component.

Also, imagine for the sake of argument, that bond markets start questioning the long-term solvency of the US government (in real terms). That is, imagine the public suddenly expected the government to start monetizing debt at an accelerated rate. The velocity of money and treasuries would quickly pick up even with the binding LCR constraint, no?

That’s an interesting question, and I don’t think the answer is obvious. If LCR is a binding constraint and monetary policy is loosened, it may be that banks have no room to just sell treasuries (i.e., HQLA) and replace them with risky assets. Moreover, it may be that looser policy increases the LCR denominator (net cash outflows) and so maintaining LCR would actually require an increase in HQLA holdings. Of course other assets (like certain corporate bonds) count toward HQLA, so changing the composition of HQLA holdings may provide some give when policy is loosened. But there is a risk-weighting factor for these other assets that highly penalizes them relative to treasuries, which could mute that effect.

This really requires the attention of someone who has up-to-date bank balance sheet expertise while also understanding monetary transmission mechanisms. I myself would be very interested to see such an analysis.

I believe that the QE results were greatly reduced by IOER. For 95 years, IOR was 0%. IOER is contractionary while QE should be expanisionary. Once the Fed Funds rate got close to zero, the Fed should have made IOER mildy negative as it started QE. This would have given us more bang for the buck (so to speak).